Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?
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NBER Working Paper No. 14386
Issued in October 2008
NBER Program(s): AP EFG
Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time-varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in the left tail. The possibility of this poor outcome results in an equity premium, while time-variation in the probability of this outcome drives high stock market volatility and excess return predictability.
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This paper was revised on December 5, 2011 Acknowledgments
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